7 of Warren Buffett’s Best Words of Wisdom from Berkshire Hathaway’s 2012 Letter

Warren Buffett has, at this point, become more legend than man in the financial world. Through Berkshire Hathaway ($BRK.A),  he gives hope to everyone that a stable, well-mannered person could rise to become one of the wealthiest men in the world simply by shrewdly investing in companies with potential. Some of his biggest winners include Coca-Cola (KO) , American Express (AXP) , Procter & Gamble (PG) , and sweet deals from companies like Goldman Sachs (GS) , General Electric (GE) and Bank of America (BAC) in recent years.

His investment philosophy has been examined and re-examined thousands of times over in hopes that investors can mimic his extraordinary success. While Buffett possesses certain financial advantages and strategic positions that most investors will never have, gaining insight into his rationale for certain moves and approaches can be invaluable all the same. Here are seven of the most insightful bits from his recent letter to Berkshire Hathaway shareholders.

Berkshire’s Performance in 2012:

“To date, we’ve never had a five-year period of underperformance, having managed 43 times to surpass the S&P over such a stretch. (The record is on page 103.) But the S&P has now had gains in each of the last four years, outpacing us over that period. If the market continues to advance in 2013, our streak of five year wins will end.”

On Hunting for Future Large Acquisitions:

“Our total investment of about $12 billion soaks up much of what Berkshire earned last year. But we still have plenty of cash and are generating more at a good clip. So it’s back to work; Charlie and I have again donned our safari outfits and resumed our search for elephants.”

On Investing and Performance Benchmarks:

“One thing of which you can be certain: Whatever Berkshire’s results, my partner Charlie Munger, the company’s Vice Chairman, and I will not change yardsticks. It’s our job to increase intrinsic business value – for which we use book value as a significantly understated proxy – at a faster rate than the market gains of the S&P. If we do so, Berkshire’s share price, though unpredictable from year to year, will itself outpace the S&P over time. If we fail, however, our management will bring no value to our investors, who themselves can earn S&P returns by buying a low-cost index fund.”

On the Virtues of Owning Insurance Businesses:

“Our insurance operations shot the lights out last year. While giving Berkshire $73 billion of free money to invest, they also delivered a $1.6 billion underwriting gain, the tenth consecutive year of profitable underwriting. This is truly having your cake and eating it too.”

On Leadership Succession of Berkshire:

“Todd Combs and Ted Weschler, our new investment managers, have proved to be smart, models of integrity, helpful to Berkshire in many ways beyond portfolio management, and a perfect cultural fit. We hit the jackpot with these two. In 2012 each outperformed the S&P 500 by double-digit margins. They left me in the dust as well.

Consequently, we have increased the funds managed by each to almost $5 billion (some of this emanating from the pension funds of our subsidiaries). Todd and Ted are young and will be around to manage Berkshire’s massive portfolio long after Charlie and I have left the scene. You can rest easy when they take over.”

On Building Intrinsic Value:

“In summary, Charlie and I hope to build per-share intrinsic value by (1) improving the earning power of our many subsidiaries; (2) further increasing their earnings through bolt-on acquisitions; (3) participating in the growth of our investees; (4) repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value; and (5) making an occasional large acquisition. We will also try to maximize results for you by rarely, if ever, issuing Berkshire shares.”

On Failure and Why Optimism is Not a Strategy:

“The usual cause of failure is that they start with the answer they want and then work backwards to find a supporting rationale. Of course, the process is subconscious; that’s what makes it so dangerous.

Your chairman has not been free of this sin. In Berkshire’s 1986 annual report, I described how twenty years of management effort and capital improvements in our original textile business were an exercise in futility. I wanted the business to succeed and wished my way into a series of bad decisions. (I even bought another New England textile company.) But wishing makes dreams come true only in Disney movies; it’s poison in business.”